Question

Briefly explain the Phillips curve relation between inflation and unemployment and its policy implications for macroeconomic management. What challenge did the Phillips curve relation pose to the Keynesians working in the economic environment of the post-War period and how did Keynesians reconcile to it? Briefly explain implication and predictive inconsistency of the Keynesian-neoclassical synthesis model.

Answer 1

In late 1950's, Sir Arthur Phillips analyzed long-term, time-series data of British economy. He found an inverse empirical relationship between the rate of change of money wages and level of unemployment. This meant that for British economy the periods of high unemployment are associated with lower wages and vice-versa. The simplest explanation of Phillips curve was that there is high unemployment, the supply of labor is high and demand is low. Hence the wages (as well as changes in wage rates) are lower than what it would be in the case of low unemployment.

Since the rate of change of money wages and rate of change of price level is highly correlated, the inverse relationship was also extended to inflation and unemployment. The subsequent studies showed that there might be an inverse relationship between inflation and unemployment.

For policymakers, Phillips curve essentially entailed a trade-off between inflation and unemployment. In other words, it was postulated that states can reduce their levels of unemployment if they are ready to bear high rates of inflation. Inversely, policymakers can also pursue low inflation (or even deflation) but at the cost of bearing high unemployment rates in the economy.

Although Phillips curve was gaining popularity, it was essentially just an empirical relation without any theoretical underpinnings that justified a trade-off between inflation and unemployment. Keynesians such as Samuelson provided a theoretical justification of Phillips curve that was in tune with the Keynesian macroeconomics. They linked the Phillips curve with changes in Aggregate demand. Keynesians, as well as Keynes himself, believed that Aggregate supply, below the full employment level, is upwards sloping. Rightward (or leftward) shift in aggregate demand curve can increase (or decrease) the price levels as well as employment as long as the output is below full employment level.

Even when Phillips curve (and the idea of inflation-employment) was becoming highly popular in 1960's, two economists challenged the theoretical arguments of Phillips curve. Friedman and Phelps believed that laborers are rational agents and they do not care about the nominal wages being given to them. Rather it is the real wage that they get is what matters to them. An increase in nominal wage rate should not increase employment if workers expect higher inflation in future.

It should be noted that even the monetarist such as Friedman did believe in the inverse relationship, but they believed that the only reason this relationship was observed in the past was that the inflation rate was very low. Hence, they proposed an inflation augmented Phillips curve and a natural rate of employment/unemployment (ie- the unemployment rate when inflation is zero).

As it turns out the inverse relation did break down in the 1970s, a period where we saw high levels of unemployment as well as high levels of inflation, simultaneously. This phenomenon which was later termed as stagflation. Hence the Keynesian predictions failed in this period. In fact, it was argued that it was the excessive use of fiscal/monetary stimulus in the 1960s (with the oil price shock of 1970s) that ultimately caused stagflation. It was during this period when the fall of Keynesian macroeconomics started and we ultimately saw the revival of neo-classical economics.